The success of the government-sponsored enterprises' credit risk transfer programs shows that they can be the basis for housing finance reform.

But there are still steps that can be taken to maximize secondary market liquidity and broaden the investor bases, according to a paper co-written by Annaly Capital Management and the Federal Reserve Bank of New York.

The various proposals for housing finance reform generally share two common goals: ensuring that mortgage credit risk is borne by the private sector, and maintaining the current securitization infrastructure as well as the standardization and liquidity of agency mortgage-backed securities markets, said the paper's authors, Annaly's Chief Investment Officer David Finkelstein, its Director of Macro Strategy Andreas Strzodka, and James Vickery, FRBNY's assistant vice president in the research and statistics group. "The credit risk transfer program, now into its fifth year, represents an effective mechanism for achieving these twin goals."

Through December 2017, Fannie Mae and Freddie Mac had transferred $62 billion of the credit risk on $1.8 trillion of mortgages using various structures.

GSE credit risk transfers

But when it comes to broadening the investor base, the authors argued against the GSEs selling the first-loss piece and catastrophic risk pieces of the risk-sharing securities.

Transferring the first-loss piece is unlikely to lead to any overall net losses for the GSEs after taking into consideration the guarantee fee income earned on the underlying mortgages. It is also of limited benefit from a risk management standpoint and it gives the GSEs skin in the game "which may help attract investors and mitigate moral hazard."

Finally, "some private investors may face high capital costs from holding first-loss tranches," the report said.

Similarly, the GSEs would see little risk management benefit from selling the catastrophic risk piece. What they should concentrate on is what they are currently doing: transferring the mezzanine credit risk associated with their guarantee portfolio, the report said.

Front-end risk transfers could eliminate some of the time lag associated with the current program, but the trade-off is a smaller investor base.

"This more limited investor universe should make for less efficient execution, in turn raising the premium for the credit risk. From a broader financial stability perspective, this approach also implies less system-wide diversification of mortgage credit risk, given that mortgage originators, like the GSEs, are significantly exposed to the housing market and are also often highly leveraged," the report said.

What will broaden the investor base is removing the regulatory uncertainty regarding whether real estate investment trusts and insurers can purchase these assets.

"We note that the CRT programs have not yet been tested by an adverse macroeconomic environment, and we cannot be certain how CRT investor demand and pricing will evolve under such conditions. Careful management of the programs will likely be needed during such an episode. As we discuss, there are also a several outstanding questions about the design of CRT instruments, and how to maximize secondary market liquidity and enhance the breadth of the investor base."

"The credit risk transfer programs will continue to grow and evolve in response to these considerations," the report said.

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